Stock Analysis

Is Exco Technologies (TSE:XTC) Using Too Much Debt?

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TSX:XTC
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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Exco Technologies Limited (TSE:XTC) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Exco Technologies

What Is Exco Technologies's Net Debt?

As you can see below, Exco Technologies had CA$8.77m of debt at December 2020, down from CA$17.1m a year prior. However, it does have CA$35.3m in cash offsetting this, leading to net cash of CA$26.5m.

debt-equity-history-analysis
TSX:XTC Debt to Equity History February 23rd 2021

How Healthy Is Exco Technologies' Balance Sheet?

We can see from the most recent balance sheet that Exco Technologies had liabilities of CA$68.3m falling due within a year, and liabilities of CA$12.2m due beyond that. Offsetting this, it had CA$35.3m in cash and CA$88.8m in receivables that were due within 12 months. So it actually has CA$43.5m more liquid assets than total liabilities.

This short term liquidity is a sign that Exco Technologies could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Exco Technologies has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Exco Technologies if management cannot prevent a repeat of the 27% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Exco Technologies's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Exco Technologies has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Exco Technologies generated free cash flow amounting to a very robust 88% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Exco Technologies has net cash of CA$26.5m, as well as more liquid assets than liabilities. The cherry on top was that in converted 88% of that EBIT to free cash flow, bringing in CA$44m. So we don't have any problem with Exco Technologies's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - Exco Technologies has 3 warning signs we think you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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